A repurchase agreement (or repo) transaction is a sale of securities coupled with an agreement to repurchase the securities at a specified price on a later date. A repo transaction is economically similar to a secured loan. Repo transactions usually involve borrowers selling securities (loan collateral) to lenders for cash today, with the understanding that the transaction is reversed on a specified end date. Repo transactions are often conducted on an overnight basis. “Term repo” transactions are held for a specific term, e.g., 1-week, 2-weeks, 1 month, etc. Borrowers that enter a repo transaction have “repoed out” the securities; lenders conduct “reverse repo” transactions. Repo trades are often collateralized by U.S. Treasury securities but may be secured by other mutually agreed collateral. At least $5 trillion (USD) is repoed daily in the U.S. with perhaps another 6.4 trillion (EUR) in Europe.
A bilateral repo transaction is a transaction between two parties that involves an assumption of credit risk by one party with respect to the other. The cash lender loans cash to a borrower and receives the borrower's securities as collateral. The proceeds of the initial securities sale can be thought of as the principal amount of the loan, and the excess paid by the cash borrower to repurchase the securities corresponds with the interest paid on the loan, also known as the repo rate. The difference between the amount of cash loaned and the value of the collateral posted is called the “haircut.” The haircut functions as a buffer for the lender against short-term variations in the value of the collateral. The haircut may also provide some protection against default.
Tri-party repo transactions are similar to bilateral repo transactions, but a third party, the tri-party agent, participates in the transaction along with the cash borrower and the cash lender or investor. Cash lenders, often money market mutual funds, have cash that they are willing to lend against collateral via the tri-party agent. Cash borrowers, typically fixed-income securities broker-dealers, seek to finance securities that can be used as collateral. Cash lenders use tri-party repos as investments that offer liquidity maximization, principal protection, and a small positive return, while cash borrowers rely on them as a major source of short-term funding. The tri-party agent facilitates transactions by providing operational services, such as custody of securities, settlement of cash and securities, valuation of collateral, and optimization tools to allocate collateral efficiently. In the U.S. market, government securities clearing banks serve as tri-party agents. Tri-party repo transactions usually settle on the books of one of two “Clearing Banks” in the U.S. market: Bank of New York Mellon (BNYM) and JP Morgan Chase (JPMC). The clearing bank, or custodian bank, is thus a third party involved in the repo transaction between the dealer (e.g., broker-dealer) or other borrower (e.g., party borrowing cash against securities collateral) and a cash investor or other lender (e.g., party lending cash against securities collateral.
Broker-dealers obtain a significant portion of financing for their own and their clients' securities inventories through the tri-party repo market. During the first quarter of 2010, the value of securities financed by tri-party repos averaged $1.7 trillion. The size of the market has declined notably since a peak of about $2.8 trillion in early 2008. The tri-party repo market nonetheless remains large and important, representing a significant part of the overall U.S. repo market in which market participants obtain financing against collateral and their counterparties invest cash secured by that collateral. Large U.S. securities firms and bank securities affiliates finance a large portion of their fixed income securities inventories, as well as some equity securities, via the tri-party repo market. This market also provides a variety of types of investors with the ability to manage cash balances by investing in a secured product, many of which are exempt securities. The importance of the U.S. repo market is underscored by the fact that it is the market in which the Federal Reserve operationally implements U.S. monetary policy.
The custodian services of the custodian banks provide protections that do not exist for bilateral repo investors or unsecured creditors. The tri-party repo structure developed in response to the desire by cash investors to have collateral held by a third-party agent. The collateral used to secure tri-party repos consists largely of U.S. Treasuries and agency mortgage-backed securities and debentures. As of the first quarter of 2010, these types of collateral represented slightly more than 80 percent of all collateral in the tri-party market. Other assets financed through tri-party repos include fixed-income securities and equities on deposit at the Depository Trust & Clearing Corporation (DTCC) as well as whole loans (currently less than one percent of assets financed). These asset types are primarily, but not exclusively, investment-grade securities. Some are materially less liquid than traditional government and agency securities.
In a typical overnight tri-party repo transaction, a cash lender and a cash borrower arrange their tri-party repo transactions bilaterally in the morning, agreeing on the tenor of the repo, the amount of cash provided, the value of the collateral provided, and the repo rate, among other parameters. The actual securities used as collateral are assigned later by the tri-party agent (or, in some cases, by the cash borrower), such that the securities meet the schedule of acceptable collateral specified by the cash lender. After the terms of the transaction are agreed upon, the dealer notifies the custodian bank. In some cases, only the very basic terms of the repo are communicated.
Late in the day, the custodian bank, adhering to the terms of the transaction provided by the borrower, settles the repos by simultaneously transferring collateral and cash between the borrower's and lender's cash and securities accounts at the custodian bank. In other words, securities are moved from the borrower's securities account to the lender's securities account and the corresponding cash amounts are transferred from the lender's cash account to the borrower's cash account. This process “locks” the borrower's securities in the lender's account. A dealer often allocates specific securities to each transaction using its clearing bank's or its own collateral optimization engine, as constrained by the schedule of acceptable collateral. Overnight, the lender holds the collateral, which exceeds the value of the cash loan by the value of the haircut, to offset the risk that the borrower will not be able to return the appropriate amount of cash the following day.
At 3:30 p.m. each day, the custodian bank extends credit to each dealer and returns the securities that were pledged as collateral so that the dealer can deliver any securities that are sold to buyers. This process of returning the collateral to the dealer is referred to as “unwinding” the repo. In overnight repo transactions, the unwinding each afternoon creates an overdraft in the dealer's cash account at its custodian bank when the custodian bank returns the repo collateral to the dealer and returns the cash borrowed by the dealer to the lender's demand deposit account.
Throughout the business day, broker-dealers buy, sell, and finance securities for their own and their client-owned positions. These securities may be delivered into and out of the dealer's securities account at its custodian bank. Either way, dealers typically do not have sufficient cash balances at their custodian bank to pay for their securities purchases during the day. Dealers use the cash they receive from lenders at the end of the day to extinguish these overdrafts.
Risk management practices may exacerbate the pressure on dealers during a credit crisis. During normal times, competitive dynamics and an abundance of market liquidity can lead investors and custodian banks to adopt liberal policies on collateral eligibility, the size and concentration of portfolios, and haircuts. During times of financial stress, the desire by investors and clearing banks to protect themselves can lead to sudden withdrawals of credit or sharp increases in margins and haircuts.
When faced with the prospect of counterparty default, neither custodian banks nor lenders may be well prepared to conduct an orderly liquidation of a large dealer's tri-party repo collateral. Either group may face challenges with respect to operational arrangements, sources of liquidity during a (potentially lengthy) liquidation period, and the impact of distressed asset prices on their own balance sheets.